NINA SHAPIRO AND MALCOLM SAWYER

Post Keynesian price theory

Abstract: This paper examines and develops the firm-centered price theory of Post Keynesian economics. It takes issue with the traditional interpretation of that theory, arguing that although its prices are cost-based, they are not costdetermined. The distinctiveness and significance of the theory are located elsewhere, in the strategic determination of prices and the conception of the firm that underlies it. The costs of firms are examined along with their prices, with special attention paid to the overhead allocations of the firm and the validity of the full cost conception of its prices. Key words: business strategy, overheads, Post Keynesian, product pricing.

While the firm has little importance in the neoclassical theory of prices, it is at the center of the Post Keynesian treatment of prices. Here, the decisions of firms matter; their prices are not determined by the conditions of their markets. The pricing power of firms is highlighted, as is the use of that power in the interests of their long-term growth and survival. Prices are rooted in the requirements of firms, and it is because they depend on the ends of the enterprise that the explanation of their levels centers on the pricing decisions of the firm. The theory of prices is, and must be, a theory of pricingit has to be about firms and the determinants of their prices.1 The firm-determined prices of Post Keynesian economics are examined below, where they are differentiated from the product values of classical and neoclassical economics and shown to entail a quite different view of price determination. The prices of the firm are neither the

Nina Shapiro is Associate Professor of Economics at Saint Peters College, Jersey City, NJ. Malcolm Sawyer is Professor of Economics at University of Leeds, U.K. This paper was presented at the Seventh International Post Keynesian Conference, Kansas City, June 2002. The authors are grateful to conference participants for comments on an earlier draft and to Richard Garrett for comments and discussion on the content of this paper. 1 The importance of the firm in Post Keynesian price theory is highlighted in Shapiro and Mott (1995). See also Sawyer (1992) and Eichner (1985).
Journal of Post Keynesian Economics / Spring 2003, Vol. 25, No. 3 355 2003 M.E. Sharpe, Inc. 01603477 / 2003 $9.50 + 0.00.

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production prices of the classical theory, nor the scarcity indices of the neoclassical, and, although they are related to the costs of products, they are not cost prices either. The prices of the firm are strategically determined rather than cost-determined, with the costs of products administered along with their prices and their full costs decided by the firm also.2 Prices and costs The firm-determined prices of Post Keynesian theory are markup prices. They are markups over the costs of products, with the costs marked up in the price of the product being the direct costs of its productionthe average variable or unit prime costsand the markup on the costs providing a margin for overheads and profit. But although prices are set relative to costs, and profit cannot be made unless the pricing of the firm takes account of its costs, prices are not decided by costs alone. There is no automatic transmission of costs into prices, and this is the case with regard to both the direct and indirect production costs of products. Prices depend on the markups of the firm as well as the costs, and when the costs of a product change, the markup on the costs can change instead of the price.3 The markup is not given with the properties of the product, nor is it determined by the conventions of the industry. It can be different at varied times (Eichner, 1976), and different in varied markets (Steindl, 1990), changing with the requirements and opportunities of the enterprise. The ends of the enterprise decide the markup on products, determining the relation between prices and costs and the extent to which prices change with costs. Prices will change if those changes serve, or are expected to serve, the interests of the firm, and, although an increase in costs in relation to price would reduce the margin for profit, an increase in price in line with costs may not be profitable. It could hurt the sale of the product (Kalecki, 1971b). The price increase could reduce the competitiveness of the firms product, increasing the price of the good relative to the prices of its substi2 Although strategic considerations affect prices in a number of different Post Keynesian theories, they are especially prominent in the investment-centered ones, where the prices of firms further their expansion. See Eichner (1976), Harcourt and Kenyon (1976), and Steindl (1976). 3 This is emphasized in Kaleckis discussion (1971b) of the differences between his markup price theory and the full cost theory. See also Kaleckis analysis (1971a) of the effects of trade union activity on markups and prices.

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tutes. The producers of those substitute goods may not have experienced the cost increase of the firmtheir location or technology could be different. They may acquire labor in different markets, purchase parts from different suppliers, or use different kinds or amounts of materials in their production processes. Their costs can be subject to different influences even if they operate in the same industry, and if their costs had not risen along with the firms, their prices might not rise in step with its own.4 Sales could be lost as a result of the price hike, and profits reduced rather than protected through the hike. And since the sales of products advertise them, validating their worth, and the popularity of products can decline with the decline in their sales, the fall in sales could itself hurt sales, bringing them down further.5 The long-run loss in sales could be much greater than the short-run loss, and the long-run sales loss matters also. Indeed, the funds invested in products cannot be recovered unless their sales are maintained, for the investments of production are long-term and irreversiblethere are no organized, secondhand equipment markets or exchanges (Davidson, 1978), and the development and marketing costs of products are sunk expenditures too. They are recouped throughand only throughthe sale of the products, and price increases can be unprofitable even if they do not bring down revenues in the short run. The maintenance of the price of a product may be needed for the preservation of its sales, and if the product is a new one, the maintenance of the price may be needed for the development of its market. The product may be promoted through its price, and the costs of trying out the new good, or switching over to its use, compensated through the price.6 An increase in the price could make the purchase of the product unattractive or uneconomical, and, if the product were a network goodthat is, if

For the empirical importance of cost differences in the pricing behavior of firms, see Sylos-Labini (1979), where labor cost differences explain the incomplete transmittal of cost changes into prices in U.S. and Italian industry. Also see the examination of markup changes in Arestis and Milberg (199394). 5 That promotional aspect of sales is especially important in the case of products whose utility or reliability cannot be known before they are used, for the sale of those experience goods depends on the reputation of their manufacturer, which is established and maintained through their sales. Computer hardware and software would be examples of such goods, as would cars and trucks, consumer electronics, and, indeed, any other complex product. 6 New products can fail, and their failure costs their users time and money; their use can require the acquisition of new skills and complementary products and, in the case of producer goods, the reorganization of production processes (Porter, 1980).

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it were used to communicate with others (like telephones and fax machines are) or in order to be like others (fad or fashion items)a price increase could jeopardize its sale. It could reduce the number of those willing or able to use the good, checking the sales growth that the utility and demand for the product depend on.7 The price may have to be held down for a user network to develop or a customer base established, and, although the price may be too low in relation to costs for a profit on the product, the price can come up when its sales are secure, and costs brought down through increases in the scale of its production and the knowledge acquired in its production. New products are sold at lower prices to new users, and at discounted prices to influential users (such as educational institutions).8 They are distributed free of charge to prospective usersa common practice in the computer software industry (Klein, 2001)and included at no extra charge in the sale of other products (Gilbert and Katz, 2001). The prices of new goods promote their sale and the growth of their sales, and whereas their promotional prices may not clear costs, and the firm would not invest in a product if it did not expect to make a profit on it, the price of a product need not cover costs at all times in its life for its development to be profitable. The profitability of a product depends not on the profit from its sale at any point of time, but on the profit earned on it over the course of its life. Moreover, some products have to be sold at a loss in the short run for their sale to be profitable in the long run. Their markets cannot be developed at their full cost prices. The prices of the firm are not given with the costs of its products, nor are they determined by the demand for them. Prices do not necessarily change with the demand for products just as they do not necessarily change with the costs, and they do not do so for the same reason: the price changes may not be in the interests of the firm. Price increases in times of rising sales can hurt customer relations and customer bases, for those increases can appear exploitative, especially if competitors have not also increased prices, and customers can shift their custom to other firms when subjected to those price rises (Okun, 1981).9 And whereas price increases in times of rising sales can cost the
7 For an extended discussion of network goods and the requisites of their sale, see Rubinfeld (1998). 8 Both of those pricing practices were used by IBM in the promotion of its mainframe computer (Waldman, 1998). 9 For the importance of customer relations in the price determinations of U.S. firms, see Blinder (1998).

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firm loyal clientele and market share, price cuts in times of falling sales can set off a ruinous price war (Eichner, 1969). The price changes that increase profits in the short run can reduce and even eliminate them in the long and medium runs, and although not all firms have the liquidity needed for a long-term perspective in their pricing, none can afford to ignore the future effects of their price changes. The time period considered in their pricing decisions must be at least as long as the time needed for the recoupment of the costs of products, and the development and equipment costs of products cannot be recouped in the short run. The time required for the recoupment of those costs is too long for the myopic time frame of the neoclassical firm (Eichner, 1976). The product pricing of the firm takes in the effect prices have on future sales, affecting the demand for products rather than reflecting it. Prices shift out demand curves instead of moving them down and reduce price elasticities rather than being determined by them. The prices of the firm develop, expand, and protect its markets, maintaining and enhancing its profitability and competitiveness, and when the firm produces different productsand few firms are the single product enterprises of the economic texts10the pricing of the firm takes in not only the effects of prices on the future sale of products but also their effects on the sale of other products. The price of a product can promote the sale of other products as well as its own. Discounts and sales attract customers, and since the transactions costs of their purchases are reduced through the purchase of products together, at the same time or place, the sale items of the firm sell the regular priced products. Products are tied to the sale of others, and their sales are increased and maintained through the prices of their complements and the prices of their lower-end substitutes (customers trade up).11 The products of a firm are not priced separately, without regard for the effect of their prices on the sale of the others. They are priced with the revenue from them all in mind, and the most profitable

10 Not only have firms become increasingly multiproduct, so have their plants (Kaplan and Johnston, 1987), and their operations have gone so far beyond those depicted in the economic texts that the firm is no longer characterized as a producer in the management literature. Firms perform activities (Kaplan and Cooper, 1998) and create value (Ostrenga et al., 1992) rather than produce products. 11 An important recent example of this use of the price of one product to support the sale of another was Microsofts predatory pricing of its Web browser, which was aimed at maintaining the monopoly of its Windows operating system (Fisher and Rubinfeld, 2001).

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price is not the price that maximizes the profit on the product, but the one that maximizes the profit of the firm (Nove, 1991).12 The costs of a product matter in the pricing decisions of the firm, but so do the sales and the sale of other products. The product price is decided strategically, by the ends it is expected to serve, and the costs of the product can be administered as well as the price. They are not given to the firm either. Full costs The costs of products go beyond the variable costs of their production. Products have to be designed, their production processes engineered, and materials and parts ordered and stored. The equipment used in their production has to be acquired and set up, and the products distributed and marketed as well as manufactured. Products have sales and indirect production costs along with direct production costs, and these do not vary with the rates of their production, nor are they determined by the technical conditions of their production. The equipment costs of a product depend not only on the equipment required in its production and the price paid for the equipment but also on the output produced with it. The equipment can produce different amounts of the product, and can produce the product over different periods of time. It is not consumed in the production of the product, being the capacity for its production rather than an input into it, and it is because the equipment is a productive capacity rather than a productive input that its amount cannot be adjusted to the output of the product. The equipment is indivisible because it produces a stream of output. Since the equipment can produce various amounts of the product, the per-unit equipment costs cannot be determined without knowledge of the amount produced, and this cannot be known while the equipment is still in use. Although the technical properties of the equipment may determine the amount of the good it can produce in any period of time, they do not decide the amount actually producedthis depends on sales volumesor the length of time over which the equipment is used. Its lifetime is not given with its technical specificationsit depends on the value of the products produced with the machinery rather than the physical
This is not to say that the firm can determine the profit-maximizing pricethere are too many uncertainties involvedbut insofar as profit is the objective of its pricing, it is the profit of the firm as a whole that matters in the determination of prices.
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durability of its construction. Indeed, there is no reason why the machinery cannot be operated indefinitely if it is maintained properly (Eichner, 1987), and without knowing the lifetime of the equipment and the degree of its utilization, the costs of its use cannot be determined. The machine time required for the production of a unit of the product can be known, but the unit machine costs cannot.13 Of course, the firm can estimate the lifetime of the machinery, and use that estimate, along with the expected or standard rate of its utilization, to determine the depreciation charge on its products. But any such allocation of the equipment costs of a product is arbitrary (Steindl, 1993). The depreciation charged to the unit of the product is not the real equipment cost of its production, and it is not the real cost not only because the firm cannot know for certain the lifetime of the machinery or the rate of its utilization but also because there is in fact no real unit machine cost. The units of the product produced with the machinery are not the driver of its cost, and it is because they are not that the number produced has to be known in order to determine the unit machine cost. The machinery is a common cost of all the units of the product produced with it (Levine, 1981).14 It is a common cost of both all the units it produces in a given period of time and all those produced over the course of its life. And although the revenue from its product must repay its costthe equipment would not be profitable otherwisenot all units of its product must return the same proportion of its cost. The cost of the equipment can be shifted across the units of the product, with the conditions of their sale deciding the depreciation charges on the units (Robinson, 1953). The units produced later in the life of the product, after its market is developed, can bear a disproportionate part of its equipment costs, as can the units sold in the more protected markets of the firm (such as the domestic ones). The costs of the equipment can be shifted temporally as well as spatially, and the depreciation charges on its output decided in accordance with the ends of the enterprise (Levine, 1981). That strategic determination of costs is also possible in the case of other product costs. The development cost of a product is not affected by the amount of the good producedthere is no real unit development

13 The difficulty of determining the output a machine will produce in its lifetime is highlighted in the cost accounting literature (see, in particular, Lewis, 1993). 14 This discussion of the overheads of the firm is heavily indebted to the discussion in Levine (1981, chs. 3 and 5).

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cost either. It is a common cost of all the units of the product produced over the course of its life, and, like the equipment cost of the product, the development cost can be moved forward in time and is so moved in practice. The costs of developing new products are charged to the established products of the firm, which pay back the cost of their own development through their financing of the development of other products. The marketing cost of a product is a common cost of all its units also, as is the expense of its distribution network. The advertisements of the product promote the product as suchits special or useful properties rather than those of any particular unit of the product (Levine, 1981). They promote the sale of all units of the product, including the ones not yet produced, just as its distribution network distributes all of them. And when the firm produces a line of products, such as a brand of cereals or clothes, the advertisements that promote one of the products in the line promote them all. Some of the sales (and development) costs of the product line are common costs of all the products in the line, and can be shifted across the products as well as across their units (Kaplan and Cooper, 1998). Whereas some of the costs of the firm are not costs of individual products but costs of classes of products, some of the costs of the firm are common costs of all its products. Its corporate advertisements and public relations promotions sell all its products, present and future, and its quality improvement and employee incentive programs improve the production of them all (its information systems do this also). Those corporate-level programs and promotions benefit the whole organization rather than just a part of it, and, whereas their expenses are firm-level expenses, other expenses of the firm are firm expenses. They are not costs of products, of producing, developing, or marketing them, individually or collectively. The expense of coordinating the various operations of the firm, and adjusting them to its ends, is a cost of the firm rather than its products. The costs of determining its future directions and courses of action are also firm costs, as are the costs of widening the field of its investments (such as its basic research and corporate acquisition costs). Those management and investment costs are driven by the needs of the firm itselfthey have no cost drivers other than the requisites of its own operation and survivaland like the firm-level expenses of the firm, these firm expenses can be shifted across all its products. The overheads of the firm are not the costs of producing products these are the prime costs of their productionbut the costs of acquiring and retaining the ability to produce them. They are expenses of the

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firms infrastructure (Kaplan and Cooper, 1998), the costs of building and maintaining its production and marketing facilities and competencies. The recoupment of overheads is needed not for the production of products, but for the reproduction of the firm, and insofar as its overhead expenses are not driven by its products or their production, they must be allocated to them. The overhead charges on products and their units have to be decided by the firm, and whether they are decided strategically or conventionally, by the ends of the firm or standard allocation practices, the result is the same: the full costs of products are determined by the firms that produce them. Products have no real, inherent, full cost of production. This is not to say that the full cost of a product can be whatever amount the firm desires. Its overhead charges on products are constrained by the necessity of recouping its overhead expenses, and recouping them within a certain period of time. The funds of the firm are not unlimited, and it cannot remain in business without the funds needed for the payment of overheads. But within the limits set by the need for the full and timely recoupment of overheads, there is room for the strategic allocation of those costs, and when strategic considerations decide the overhead charges on products, their full costs reflect the same enterprise objectives that determine their prices. The full cost of a product depends as much on its price as the price depends on its full cost, and the price of the product cannot be explained by the full cost of its production. There is no full cost independent of the price to explain it. The firm can administer its costs as well as its prices, shifting its overheads across products and time, and deciding the full cost of products together with their prices. And, although the direct costs of their production may be given with their properties, these can be altered too. Products can be redesigned, with a certain manufacturing cost targeted in their design (Ostrenga et al., 1992),15 and the prime costs of their production brought into line with the ends of the enterprise. Firm-determined prices The firm has an existence separate from its products, with an identity of its own. It is a pool of resources (Penrose, 1968) rather than a blueprint of technologies, an organization of production, not the production function
15 For the mechanics of target costing, see Kaplan and Cooper (1998, ch. 11 appendix), and, for an illuminating discussion of its use, see Kaldors discussion (1985, pp. 6668) of Fords development of the Model T.

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of a product. And although profit is the overriding objective of the firm it could neither survive nor grow without it16its prices do not maximize profit. And this is the case not only because the firm cannot foresee all the consequences of its actions and thus cannot know the price that will maximize profit. It is also because profit maximization assumes given cost and demand conditions, and neither the cost of products nor the demand for them is taken as given in the product pricing of the firm. The product pricing of the firm is forward-looking and strategic, and although this makes its prices less determinate than the prices that maximize profit, it does not make them indeterminate. The factors that affect prices can be identified even if their levels cannot be predicted, for the strategies that determine them are ways of maintaining and enhancing the profitability of the firm, and the requisites of firm growth and survival are as determinate as the requisites of market clearance or product production. Firms differ in the ways in which, and the extent to which, they meet the requisites of their operation, but not in the necessity of doing so. All must meet them to succeed. The requirements of firms are at the center of Post Keynesian price theory, which takes in the importance of their pricing power, and draws out the implications it has for the determination and behavior of prices. Prices reflect the interests of firms rather than the conditions of their industries or markets. They are strategically determined rather than costor demand-determined, and it is that strategic determination of prices, and the conception of the firm that underlies it, that gives the Post Keynesian theory its realism and significance. REFERENCES
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16 Profit is needed for the financing of investment, and investment in products and production processes is essential to the success of the firm. For an extended discussion, see Eichner (1976).

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